Friday, September 07, 2012

Good Spending and Borrowing by the Government -- Some Very Recent Examples

-- Posted by Neil H. Buchanan

After the first week of classes this semester, a student told me that she had read some of my on-line writings and was surprised to see that I do not think of federal budget deficits as horrible, horrible, horrible. She was neither endorsing nor condemning the standard view. Instead, she was simply saying that she had never seen anyone make the case for deficits, and she wanted me to explain why I do not think that deficits are to be avoided at all costs and at all times.

In the last paragraph of yesterday's post, I offered shorthand version of a response to that student's query: "Some fiscal deficits are bad. Some are good. As a long-term proposition, it does not make sense to run annually balanced (or even long-term balanced) budgets. Debt should rise over time. Some government spending is bad. Some is good. Apparently, that is not easy to understand." Indeed, it is not.

In response to my post, one of the regular commenters here on Dorf on Law offered some thoughts on the comments board about the importance of one kind of "good deficit" -- that is, public investment. I heartily agree with those comments. Today, therefore, I will use this opportunity to restate the case for public investment, using two very recent news stories to support the argument.

Regular readers of this blog know that I have done a lot of writing about productive public investments by governments (federal, state, and local). In fact, one of my law review articles from last year carries the title: "Good Deficits: Protecting the Public Interest from Deficit Hysteria." (A related -- and much shorter -- Dorf on Law post is available here.) In that article, I argued that the federal government should change its budget accounting system to make it clear when spending (even spending that is financed by deficits) is good for the economy, now and in the future. (In addition to public investment, the other category of "good deficits" is anti-recessionary spending and some types of tax cuts, together more commonly known as the dreaded "stimulus.")

But what exactly is this public investment, and why is it acceptable to borrow money (and thus "burden future generations with debt") to pay for it? The standard short list is usually something like this: infrastructure, education, basic research, and early childhood nutrition programs. All of those are certainly good examples of activities that the government (especially the federal government) is best suited to plan and finance (and, often, to run directly). They are also, however, so broad as to be difficult to explain in flesh-and-blood terms.

In the last two days, The New York Times has run news articles describing two particularly potent examples of good government investment projects. Today, in "New Orleans Levees Hold, and Outsiders Want In," a reporter describes the success of the post-Katrina infrastructure spending that was designed to protect New Orleans from a repeat of the devastation that we saw seven years ago this month. With Hurricane Isaac now a part of history, we know that "the $14.5 billion system that has sprung up since then passed its first test." It was so successful, in fact, that people who live outside of the protected area are wondering why they are not being similarly protected.

Naturally, any public investment project should be subjected to skeptical financial analysis, comparing the cost of the project itself against the avoided harms. (That kind of financial analysis is precisely what my "Growth Budgeting Board," in my "Good Deficits ..." article that I mentioned earlier, would mandate as a matter of course for all potential investment projects.) In this case, it is rather difficult to imagine how the balance does not come out massively in favor of the spending that was done on the levees. For under fifteen billion dollars, we protected an entire city from not only this storm, but (with appropriate maintenance -- funds for which would surely be cut by a Romney/Ryan administration) from storms for years to come. The areas outside of the currently protected zone might not pass that test (although they might), but we should stop for a moment to consider what the news would be like from the Gulf Coast today if those levees had not been rebuilt and improved.

In short, this is what a good, productive government investment in infrastructure can look like. Preventive action allows us to avoid billions in rebuilding costs, to say nothing of the human devastation that could have been part of a repeat of Katrina.

Similarly, yesterday's news included this article: "Bits of Mystery DNA, Far From ‘Junk,’ Play Crucial Role." The article describes a massive scientific undertaking, in which 440 researchers from 32 laboratories spent nearly a decade addressing a set of questions that the Human Genome Project (another hugely important government-financed research program) had made tractable. Two of the researchers analogized their work to a Google Maps version of human DNA. I do not pretend to understand the science at anything more than a pedestrian level, but the findings have apparently changed the face of scientific knowledge. Objects within DNA that had been dismissed as "junk" turned out to be "gene switches," which are a key to understanding how diseases develop in some people but not others.

The article did not provide a dollar figure for the project, but it did point out that it was federally funded. (The total was surely in the tens of billions of dollars, at least.) Because this is basic research, moreover, measuring the benefits is a tall order. Even so, we have a perfect example of a research project that no private company would have financed (for perfectly good, profit-driven reasons), providing scientific payoffs that could change the future of medicine and public health. Moreover, the scientific community has put in place careful quality control mechanisms, including strict peer review, to prevent these projects from devolving into money pits. Even though it is surely true that some government investments fail, the payoffs from something this momentous can more than make up for the dry holes.

These are certainly examples of "good spending," but what about "good deficits"? Just because the money is spent on good projects, is there not something different about borrowing to pay for them? The short answer is simply no. The easiest way to think about this is to notice that both of the projects described above were, in fact, financed with borrowed funds. We know this because, had those projects not been undertaken, the deficit would have been lower, and the government would now owe less total debt than it does.

Should we, therefore, have decided not to spend this money, simply because it had to be borrowed? What about our children and grandchildren, who will supposedly be burdened by that debt? The easiest way to think about this is to imagine having to justify the borrowing to one's hypothetical future heirs. I doubt that anyone would have difficulty explaining that handing future generations the bill for that DNA research, while also handing them the benefits of that research, was an act of generosity to future generations, not an act of selfishness. They are, quite simply, better off because we spent money on this, rather than spending money on consumer items for ourselves (or simply not borrowing it, and letting it sit in banks that cannot lend the money that is sitting on their books).

It turns out, moreover, that the argument for borrowing money to finance public investment still holds, even when one has the option of raising taxes to pay for the projects up front, as I explained in a post a few years ago. For our current situation, however, that wrinkle is simply irrelevant. Borrowing every year, to finance the projects that are probabilistically likely to provide a net benefit to the country, is simply good economics.

Yesterday, I said that liberals and Democrats were being "dumb" about using anti-deficit rhetoric to pump up Bill Clinton's record. It is, however, true that there are "bad deficits," including nearly all of the changes in the federal balance sheet from 2001-2008. Therefore, Democrats are not always wrong to say that the economy (and future generations) are harmed by poorly conceived policies that are financed by government borrowing. The point is that the policies are poorly conceived, however, not that the money was borrowed.

The larger point, however, is that a well-run government, even in a non-recessionary economy, would run a positive deficit every year. Sometimes, understanding that basic idea can seem a bit abstract. When we see the clear payoff from spending on the New Orleans levees and the DNA project, however, it becomes very real. Lives have already been saved, and more will be saved and improved, because of this spending. We must continue to make these investments.

4 comments:

You seem to only be addressing half the argument. The choice is not simply between whether to raise taxes or to run a deficit; the question is whether money should be diverted from other projects (since governments are surely guilty of bad spending as well as good spending), raised through taxes before- or after-the-fact or through out-and-out deficit borrowing (as well as any choices thereof). If there is money wasted on other projects and borrowing is done rather than make diverted from bad spending projects, then your claim doesn't necessarily pan out, regardless how "good" the project in question might be.

Public investment is a complicated concept, and Nigel Declan is right that this particular post doesn't cover every aspect of it. The specific concern that he raises is, in fact, part of the inquiry.

"If there is money wasted on other projects and borrowing is done rather than make diverted from bad spending projects, then your claim doesn't necessarily pan out, regardless how "good" the project in question might be."

Yes and no. The whole idea behind proper accounting is to compare any possible government spending project to it's BEST possible alternative, which would be what the private sector would do with the resources if the government hadn't "commandeered" them. If a perfectly "good" private investment that would have paid an internal rate of return of 4% annually is pushed aside in favor of a public project that pays 14% annually, then obviously public investment is still "good spending," notwithstanding the fact that what it is replacing is not in some absolute sense "bad." Borrowing the money at 1.6% (today's long-term borrowing rate) means that the private sector thinks that its best projects have a lower payoff than that, so even if the government borrows (rather than replacing purely "bad" spending), it is still possible to justify the public investment.

Of course, in the current situation of prolonged economic slack, there are plenty of resources available that would be doing nothing (and, especially in the case of people, decaying as productive assets), so the government's projects have a much lower threshold to clear before making sense.

A lot has been written (both at DOL and other places) that it is currently an opportune time for the US to engage in 'good borrowing'. This has been based on the fact that interest rates (and government yields) are at historical lows and the US dollar remains strong - which leads to relatively cheap borrowing.

Given however that credit rating agencies are suggesting that without a medium term improvement in the deficit, the US faces a potential credit downgrade, is there the risk that such a strategy could backfire? That is, would borrowing costs become significantly more if yields increase and there is a flight of money from the US?

Good question from Alexander Karvosh. Two quick responses (to a question that clearly deserves more than quick responses): (1) Don't believe credit rating agencies on this subject. Their pronouncements on the US debt situation have been orthogonal to reality, but parallel to budgetary orthodoxy. (2) Much more importantly, yes, it is always possible that borrowing costs could rise in the future. That can only happen, however, if we engage in bad borrowing, not good borrowing (because good borrowing lowers long run indebtedness, relative to GDP). And even if we do more bad borrowing than good borrowing, we would be foolish to pass up most of the truly good spending opportunities that are out there. We might decide to take a pass on a few marginal ones, but there is so much low-hanging fruit right now that we're nowhere near that margin.